Efforts to Shed Light on High Frequency Trading

Tue, 20 Dec 2011 02:55:29 GMT

On Dec. 13, the Commodity Futures Trading Association’s Technology Advisory Group held its year-end meeting. There were three items on the agenda. One of these was how to define and classify high-frequency trades (HFT) for purposes of monitoring their impact on the markets.

About 15 months before, the Financial Industry Regulatory Authority had fined Trillium Brokerage Services $1 million for an illicit trading strategy in which HFT featured prominently. That sanction also involved separate fines for several of the individuals involved. Their offense? they had used rapid-fire trades in a way that gave the false appearance of buy or sell-side pressure in order to generate momentum, thus giving them the opportunity to trade against that momentum.

In November 2011, Commissioner Scott D. O’Malia proposed that a definition of HFT should address seven points: high speed order submission, cancellation, or modification; algorithmic decision making without human direction on a trade-by-trade basis; co-location services, direct market access, or analogous devices to minimize network latency; very short time-frames for the creating and liquidation of positions; high daily portfolio turnover; cancellation of numerous orders within milliseconds of their submission; and flatness at the end of day (i.e. no significant overnight carry of positions).

Tom Gira, FINRA’s head of market regulation, who took part in the CFTC TAG’s panel discussion Tuesday, appreciates O’Malia’s contribution to the discussion but was concerned that an overly narrow definition of HFT will prove counter-productive. A narrow definition will allow traders using strategies analogous to, but often more complicated than, those involved in the Trillium case to rewire their strategy and avoid monitoring.

FIA Reaction

On December 12, in advance of the CFTC TAG discussion, the Futures Industry Association Principal Traders Group (FIA/PTG) submitted a three-page reply to O’Malia’s thoughts. It begins with the observation that O’Malia’s suggestions involve inherently arbitrary distinctions (words such as “high,” “very short,” “numerous” would require them).

The FIA then suggests a different approach. Instead of concerning itself with HFT, the CFTC should define a new category of trader as a “Direct ATS Participant.” The key non-arbitrary concern is with traders that use automated trading systems (ATS’) which are directly connected to an exchange. Such issues as whether or not a trader holds positions over night can then drop out of consideration.

The term ATS itself is widely used and clearly enough understood. For example, the electronic trading specifications of the CME Group’s Globex define an ATS as “a system that automates the generation and routing of orders,” and the CME requires every order to Globex to indicate whether it originated from such a system.

Other exchanges, such as NYSE LIFFE US and ICE, have similar rules. As a result, they compile lists of market participants that meet such definitions, and such lists as well as related data can be made available to the CFTC for study.

The FIA also suggests that if the CFTC is going to proceed with a study of either HFT or Direct ATS Participants, it should “consider representatives beyond the current Technology Advisory Committee members who have special experience and expertise in the issues” for a working group.

A Flash Crash and a Light Pool

Two of the participants in the panel discussion Tuesday, Wes Bethel and David Leinweber, are among four scholars affiliated with the Lawrence Berkeley National Laboratory who co-authored a recent study on “Federal Market Information Technology in the Post Flash Crash Era.” Their study portrays HFT as one of the factors that has made old-fashioned circuit breakers (as a check on volatility in crises) obsolete. In order to develop more discriminating instruments to the same end, they said, regulators will need to develop real-time high-frequency monitoring.

One point often passed over in such discussion, though, is that the private-sector interests threatened by an unchecked race to zero latency can be expected to act in their own interests. The direction for such movement may be illustrated by the launch of a “Light Pool,” by Credit Suisse, earlier this year. Impressed by the demand from the buy side for a trading facility where they could not be taken advantage of by the zero-latency wizards, and Credit Suisse created an ECN specifically excluding opportunistic trading, defined as short term alpha from customer fill, as measured by an objective quantitative formula.

At the same meeting, the TAG also discussed expectations for the new trading environment of swap execution facilities (SEFs) under the Dodd-Frank Act and interim recommendations from the subcommittee on data standardization on universal product and legal entity identifiers.

Any effort to clarify definitions and draw out the differences between constructive and destructive behaviour is to be welcomed. Whether they have got it right is another matter, but this has to be viewed as a constructive input to the policy debate. The industry needs to do a much better PR job of articulating the difference between constructive and destructive conduct in terms accessible to the informed layman. A bigger problem is how to communicate in way that addresses populist concerns- even concepts as broad as "banking" suffer from pariah status these days, so how to draw out the rationale for something as technical and arcane as automated trading? I think low industry tolerance of inappropriate behaviour is a starting point - perhaps a set of protocols that describe what is acceptable. Inappropriate behaviour tarnishes everyone. If the industry doesnt agree its own protocols through informed debate then its inevitable a regime will be exposed on it, and the basis is likely to be less well informed!